Comment: More stories highlight just how precarious the eurozone’s finances are right now. There are $2.6 trillion in loans to Portugal, Ireland, Italy, Greece, and Spain (the P.I.I.G.S), that are held by Europe’s banks. No one knows whois holding how much of those loans. As a result, terror grows in the European financial community about the many hidden financial time bombs sitting on banks’ balance sheets. This is very reminiscent to the lead up to the Lehman/AIG meltdown of 2008.

European banks’ overnight deposits with the European Central Bank rose to a record high last week, because they didn’t want to lend to each other over uncertainty that their borrower (a fellow bank) wouldn’t be able to pay their overnight loans–that’s a sign of serious wariness amongst the big banks.

Excerpt: Overnight deposits with the European Central Bank rose to a record yesterday as the sovereign debt crisis made banks wary of lending to each other.

Banks lodged 320.4 billion euros ($394 billion) in the ECB’s overnight deposit facility at 0.25 percent, compared with 316.4 billion euros the previous day, the Frankfurt-based central bank said in a market notice today. That’s the most since the start of the euro currency in 1999. Deposits have exceeded 300 billion euros for the past five days.

Banks are parking cash with the ECB amid investor concern that a 750 billion-euro European rescue package may not be enough to stop the crisis from spreading and spilling into the banking industry. The ECB said on May 31 that banks will have to write off more loans this year than in 2009 and their ability to sell bonds may be hampered as governments seek to finance fiscal deficits.

“The banking crisis is back,” said Norbert Aul, an interest-rate strategist at Commerzbank AG in London. “The news flow over the past few weeks has spooked banks and since nobody knows how exposed individual financial institutions are, it’s deemed safer to park cash with the ECB rather than lend it on.” . . .

A New York Times article notes that the bad debt spooking the European banks totals a mere $2.6 trillion! The article also talks about Depfa, a subsidiary of the German state owned bank Hypo-Real Estate Holding. Depfa was bought by Hypo in 2007, right before the subprime crash (The German state-owned banks are the fall guys in all sorts of financial bubbles. Five out of nine of them have required bailouts recently according to the article). Depfa is one of the few European banks to give detailed information about its finances. The picture is bleak. Hypo has about 80 billion euros in exposure to the P.I.I.G.S. That’s not chump change. One might guess that Depfa is giving its info because Hypo was nationalized last year as a part of the 2008 bailout related to its massive losses from the subprime mortgage backed securities sector, the meltdown in Iceland, and other financial “irregularities.”

Like IKB (the subsidiary of German state-owned bank KfW that was involved with the Rhineland Funding/Rhinebridge Capital and the scamming of US municipalities), Hypo-Real Estate was also delving into the US municipalities market. In addition, 25% of Hypo-Real Estate was also bought by Billionaire financier J.C. Flowers. (J.C. Flowers is a billionaire ex-Goldman partner that has spent the year successfully pushing to change the laws preventing private-equity firms from buying majority holdings in US banks using). Flowers, Hypo, and Nordstream (another German state-owned bank) went on to play a big role in fueling the Icelandic financial bubble. Hypo and Nordstream both had to get big bailouts as a result and there was a big fight over the nationalization of Flowers’ 25% share of Hypo.

That’s the amount that foreign banks and other financial companies have lent to public and private institutions in Greece, Spain and Portugal, three countries so mired in economic troubles that analysts and investors assume that a significant portion of that mountain of debt may never be repaid.

The problem is, alas, that no one — not investors, not regulators, not even bankers themselves — knows exactly which banks are sitting on the biggest stockpiles of rotting loans within that pile. And doubt, as it always does during economic crises, has made Europe’s already vulnerable financial system occasionally appear to seize up. Early last month, in an indication of just how dangerous the situation had become, European banks — which appear to hold more than half of that $2.6 trillion in debt — nearly stopped lending money to one another.

Now, with government resources strained and confidence in European economies eroding, some analysts say the Continent’s banks have to come clean with a transparent and rigorous accounting of their woes. Until then, they say, nobody will be able to wrestle effectively with Europe’s mounting problems.

“The marketplace knows very little about where the real risks are parked,” says Nicolas Véron, an economist at Bruegel, a research organization in Brussels. “That is exactly the problem. As long as there is no semblance of clarity, trust will not return to the banking system.”

Limited disclosure and possibly spotty accounting have been long-voiced concerns of analysts who follow European banks. Though most large publicly listed banks have offered information about their exposure — Deutsche Bank in Frankfurt says it holds 500 million euros in Greek government bonds and no Spanish or Portuguese sovereign debt — there has been little disclosure from the hundreds of smaller mortgage lenders, state-owned banks and thrift institutions that dominate banking in countries like Germany and Spain.

Depfa, a German bank that is now based in Dublin, is one of the few second-tier European banking institutions that have offered detailed disclosures about their financial wherewithal, and its stark troubles may be emblematic of those still hidden on other banks’ books.

Despite boasting as recently as two years ago of its “very conservative lending practices,” Depfa, which caters primarily to governments, has flirted with disaster. It narrowly avoided collapsing in late 2008 until the German government bailed it out, and today its books are still laden with risk.

DEPFA and its parent, Hypo Real Estate Holding, a property lender outside Munich, have 80.4 billion euros in public-sector debt from Greece, Spain, Portugal, Ireland and Italy. The amount was first disclosed in March but did not draw much attention outside Germany until last month, when investors decided to finally try to tally how much cross-border lending had gone on in Europe.

Before Greece’s problems spilled into the open this year, investors paid little heed to how much lending European banks had done outside their own countries — so it came as a surprise how vulnerable they were to economies as weak as those of Greece and Portugal.

“Everybody knew there was a lot of debt out there,” said Nick Matthews, senior European economist at Royal Bank of Scotland and one of the authors of the report that tallied up Greek, Spanish and Portuguese debt. “But I think the extent of the exposure was a lot higher than most people had originally thought.”

Concern has quickly spread beyond just the sovereign bonds issued by the three countries as well as by Italy and Ireland, which are also seriously indebted. Private-sector debt in the troubled countries is also becoming an issue, because when governments pay more for financing, so do their domestic companies. Recession, along with higher interest payments, could lead to a surge in corporate defaults, the European Central Bank warned in a report on May 31.

Hypo Real Estate has hundreds of millions in shaky real estate loans on its books, as well as toxic assets linked to the subprime crisis in the United States. In the first quarter, it set aside an additional 260 million euros to cover potential loan losses, bringing the total to 3.9 billion euros. But that amount is a drop in the bucket, a mere 1.6 percent of Hypo’s total loan portfolio. Hypo has not yet set aside anything for money lent to governments in Greece and other troubled countries, arguing that the European Union rescue plan makes defaults unlikely.

The European Central Bank estimates that the Continent’s largest banks will book 123 billion euros ($150 billion) for bad loans this year, and an additional 105 billion euros next year, though the sums will be partly offset by gains in other holdings.

Analysts at the Royal Bank of Scotland estimate that of the 2.2 trillion euros that European banks and other institutions outside Greece, Spain and Portugal may have lent to those countries, about 567 billion euros is government debt, about 534 billion euros are loans to nonbanking companies in the private sector, and about 1 trillion euros are loans to other banks. While the crisis originated in Greece, much more was borrowed by Spain and its private sector — 1.5 trillion euros, compared with Greece’s 338 billion.

Beyond such sweeping estimates, however, little other detailed information is publicly known about those loans, which are equivalent to 22 percent of European G.D.P. And the inscrutability of the problem, as serious as it is, is spawning spoofs, at least outside the euro zone. A pair of popular Australian comedians, John Clarke and Bryan Dawe, who have created a series of sketches about various aspects of the financial crisis, recently turned their attention to the bad-debt problem in Europe. After grilling Mr. Clarke about the debt crisis in a mock quiz show, Mr. Dawe tells Mr. Clarke that his prize is that he has lost a million dollars. “Well done,” says Mr. Dawe. “That’s an extraordinary performance.”

On a more serious front, Timothy F. Geithner, the United States Treasury secretary, visited Europe at the end of May and called on European leaders to review their banks’ portfolios, as American regulators did last year, to separate healthy banks from those that need intensive care.

Others say that if such reviews do not occur, the banking sector in Europe could be crippled and the broader economy — dependent on loans for business expansions and job growth — could stall. And if that happens, says Edward Yardeni, president of Yardeni Research, the Continent’s banks could find themselves sinking even further because “European governments won’t be in a position to help them again.”

LENDING practices at Depfa may have seemed conservative before its 2008 meltdown, but its business model had always been based on a precarious assumption: borrowing at short-term rates to finance long-term lending, often for huge infrastructure projects.

From its base in Dublin, where it moved from Germany in 2002 for tax reasons, Depfa helped raise money for the Millau Viaduct, the huge bridge in France; for refinancing the Eurotunnel between France and Britain; and for an expansion of the Capital Beltway in suburban Virginia. Depfa was also a big player in the United States in other ways, like lending to the Metropolitan Transportation Authority in New York and to schools in Wisconsin.

Before the current crisis, Depfa was proud of its engagement in Mediterranean Europe. In its 2007 annual report, the company boasted of helping to raise 200 million euros for Portugal’s public water supplier and 100 million euros for public transit in the city of Porto. In Spain, it helped cities such as Jerez refinance their debt and helped raise money for public television stations in Valencia and Catalonia as well as raise 90 million euros for a toll road in Galicia. And in Greece, Depfa raised 265 million euros for the government-owned railway and in 2007 told shareholders of a newly won mandate: providing credit advice to the city of Athens.

Depfa said it performed a rigorous analysis of the creditworthiness of its customers, including a 22-grade internal rating system in addition to outside ratings. More than a third of its buyers earned the top AAA rating, the bank said in 2008, while more than 90 percent were A or better.

The public infrastructure projects in which Depfa specialized were considered low-risk, and typically generated low interest payments. Yet because long-term interest rates were typically higher than short-term rates, Depfa could collect the difference, however modest, in profit.

To outsiders, Depfa still looked like a growth story even after the subprime crisis began in the United States. Hypo Real Estate, which focused on real estate lending, acquired Depfa in 2007. After the acquisition, Depfa kept its name and its base in Dublin.

But when the United States economy reached the precipice in September 2008, banks suddenly refused to make short-term loans to one another, blowing a hole in Depfa’s financing and leaving it with a loss for the year of 5.5 billion euros and dependent on the German government for a bailout.

As Hypo’s 2008 annual report said of Depfa: “The business model has proved not to be robust in a crisis.” . . .

Discussion

One comment for “BOHICA [Bend Over, Here It Comes Again], pt. 3: Major Red Ink on European Banks’ Books”

Ok, so it turns out that more than half of the outstanding mortgages in Denmark are the kind where the principal payment could be postponed up to 10 years. Fortunately, with one-year adjustable-rate loans averaging only 0.42%, the nightmare scenario of high interest rates getting introduced to this environment appears to be a no where in sight. Unfortunately, foreclosures rates are rising anyways and banks are still issuing more interest-only loans than any other type of mortgage, so this interest rate risk is going to remain for quite some time. The Danish Central bank is urging banks to restrict the issuances of these types of loans but the banks appear to view these are helpful to the consumer. The banks are also in a bit of a bind because, by law, they aren’t allowed to extend underwater interest-only loans without a write-down. And Denmark has the third largest mortgage bond market in the world. This is probably not going to end well:

Denmark’s $500 billion mortgage industry is looking at how to keep struggling homeowners afloat as the nation’s push into interest-only loans a decade ago now threatens a jump in losses amid rising unemployment.

Loan writedowns for mortgage banks in Denmark jumped 51 percent in the first half of last year, according to a report released last month from the financial regulator. Losses rose 17 percent in 2011, compared with a 25 percent drop in provisions at 35 of Germany’s largest credit banks and a 55 percent drop in net loan losses at Sweden’s mortgage lenders.

Loans that allow principal payments to be postponed by as many as 10 years now comprise more than half of outstanding mortgages after being introduced in 2003. Denmark’s two mortgage banking groups, whose members include Nykredit A/S, Europe’s biggest issuer of home-loan backed bonds, are in talks with regulators on how to help homeowners unable to meet principal payments or refinance into similar loans.

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Escalating loans losses, coupled with signs interest rates are on the rise, could stall efforts in Denmark, home to the world’s third-largest mortgage bond market, to emerge from a four-year slump in its housing market. Home foreclosures jumped to the highest in two decades last year as the economy contracted, even amid record-low interest rates and signs the housing market stabilized.

The yield on Denmark’s government bond maturing 2023 has jumped 25 basis points since a low in the first week of December to about 1.55 percent. Danes’ finances got a boost last year from investor demand for their AAA rated mortgage bonds amid a flight from the struggling euro area. The yield on one-year adjustable-rate loans averaged 0.42 percent in recent auctions, the mortgage association said Dec. 17. The Nykredit index of the market’s largest, most traded mortgage bond series, hit a record 404.72 last month.

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Forced Writedowns

More foreclosures could trigger another downward spiral in the housing market. Households have too much debt and the cost of that debt is likely to worsen as rates go up, weighing on the market, said Andreas Hakansson, an analyst at Exane BNP Paribas.

“This problem will only become bigger over time as more households lose their interest-only status at the same time,” Hakansson said in an e-mail response to questions.

Mortgage banks by law can lend 80 percent of a property’s value. Homeowners whose property values have dropped, pushing loan-to-value ratios above 80 percent, can refinance though generally only to mortgages that require principal. Lenders that extend the interest-only period must write down the loans.

“That’s not a very good solution for the mortgage banks,” Karsten Beltoft, director of the Mortgage Bankers’ Federation, said in an interview. “Banks will have to write down customers and they don’t want to do that.”

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Interest-only loans made up 56 percent of outstanding mortgage bank debt after climbing 4.7 percent in the third quarter from the same period a year earlier, the Copenhagen- based mortgage association said in October. That compares with 55 percent a year earlier.

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Danish central bank Governor Nils Bernstein has urged banks to restrict use of interest-only loans. While the bank found in a December report most household budgets are “robust” and can survive a longer period of joblessness or rising rates, it concluded the loans introduce imbalances in households and the mortgage industry and inflate house prices.

The industry has defended the loans, saying the products and adjustable-rate mortgages have helped soften the effect of the economic contraction and helped keep people in their homes. Foreclosures fell in December to 363 from 451 a month earlier, the Copenhagen-based statistics agency said.

“We don’t think these are a mistake,” Knoesgaard said. “It’s not black and white only.”